EconSouth (Third Quarter 2002)

EconSouth (Third Quarter 2002)

INTERNATIONAL FOCUS

A Mixed Blessing: Oil and Latin American Economies

Latin America’s role as a key supplier of crude oil to the United States has received renewed attention as this country seeks to reduce its dependence on crude-oil imports from the Middle East. But within Latin America, many countries struggle to deal with the effects of volatile oil prices.

he United States depends on Latin America for a significant portion of its oil. In 2001 Mexico and Venezuela were respectively the second- and fourth-largest suppliers of U.S. oil imports, and for the month of May 2002, Mexico surpassed Saudi Arabia as the largest single supplier of crude oil to the United States. Yet only a few Latin American countries — Venezuela, Mexico, Ecuador and Colombia — are large net oil exporters. Some countries, like Argentina, have become self-sufficient and have begun to export oil while others, including Brazil, seek self-sufficiency in the coming decade. The rest of the region, however, resembles the United States in its dependency on oil imports. The bottom line is that oil has a significant effect on the economy of every Latin American country.

Oil’s importance to Latin America
Latin America’s oil economy and volatile oil prices have varying impacts on the region’s economies. High oil prices help large producers like Venezuela and Ecuador that rely on exports for fiscal revenue and foreign exchange. For the net oil-importing countries of Brazil, Peru and Chile, the price of oil is a key determinant of inflation, the cost of production, the trade balance and the strength of the currency. Oil prices today are extremely volatile, and sharp fluctuations in oil prices contribute to macroeconomic volatility in the region. Over the past 20 years, oil prices have been more volatile than the prices of other commodities like raw agricultural products, ores and metals. The impact of this volatility varies according to a country’s relative dependence on oil production and exports.

Oil dependency: Curse or blessing?
While individual nations might expect their large oil reserves to pave the way for economic development, the region’s major oil-exporting economies have experienced difficulty in converting oil revenues into a continuous source of financing for economic growth and development. Oil exports have represented a greater share of gross domestic product (GDP) in Venezuela and Ecuador than in any other country in the region over the past 20 years, yet both economies have experienced lower-than-average economic growth and higher inflation. Exports since the 1980s have averaged 20 percent of GDP in Venezuela and 10 percent of GDP in Ecuador.

One reason for the poor performance of these two oil-exporting economies is the fact that the extensive revenue from oil exports may be crowding out development in other economic sectors. This explanation, known as “Dutch disease” (named after the impact of North Sea gas on the Dutch economy), suggests that the returns on investment in oil are so large that they divert investment from other economic activities. In addition, the oil industry is capital-intensive, which means that it generates less employment per dollar invested in new capital than other more labor-intensive industries.

Another drawback for these oil-dependent economies is that they can be further hurt by the impact of volatile oil export revenues on the exchange rate. A surge in export revenues can lead to a surplus in a nation’s balance of payments, which results in a stronger domestic currency. Foreign-exchange appreciation can have some unexpected spillover effects for other parts of the economy. Appreciation of domestic currency results in a loss of competitiveness in other economic sectors as imports become cheaper and exports more expensive. Even if domestic currency depreciates, local manufacturers of tradable goods who were disadvantaged when the currency was strong may still be unable to fully capitalize on the improved exchange-rate environment if the volatility in the currency discourages investment in other industries.

CHART 1
Venezuela’s Oil Export Revenues and Fiscal Balance

Source: World Development Indicators, World Bank (2002)

The examples of Venezuela and Ecuador demonstrate that growth in oil exports does not necessarily translate to overall economic growth. During the past decade, oil exports increased on average 10 percent per year in these two economies, but their overall economic growth rates reached on average only 1 and 2 percent, respectively. In Mexico, a country less dependent on oil than Venezuela or Ecuador, real GDP grew on average 3.6 percent, and oil exports increased on average 5 percent between 1991 and 2000. In a less oil-dependent economy like Mexico, greater diversification of production can partially compensate for volatility in the oil sector.

For governments that are highly dependent on oil export revenue, fluctuations in the price of oil can have a major impact on the fiscal balance. As oil prices rise, governments are able to finance public expenditures. However, when export revenues decline, there will inevitably be a fiscal shortfall. Oil stabilization funds represent one effort to compensate for oil price volatility (see the sidebar), but a basic fact of political economy remains that governments find it far easier to raise expenditures than to cut them.

In Venezuela, Ecuador and Bolivia a strong relationship exists between fiscal balance and oil export revenues as a percentage of GDP (the impact of oil revenue on fiscal balance in Venezuela is highlighted in chart 1). In contrast, Mexico’s economy was once highly dependent on oil export revenues, but the country has seen its fiscal accounts improve even as oil export revenue as a percentage of GDP has declined (see chart 2).

Mexico’s government remains dependent on the state-owned oil company, Pemex, for 37 percent of its revenue; however, the government has made significant strides in reducing fiscal deficits in the 1990s (see the sidebar). Mexico’s successful export diversification and consequent reduced dependency on oil is due in part to its implementation of structural reforms in the late 1980s and 1990s. By comparison, reforms in Venezuela and Ecuador have lagged behind the rest of the region.

CHART 2
Mexico’s Oil Export Revenues and Fiscal Balance

Source: World Development Indicators, World Bank (2002)

Trade balance
For countries dependent on oil exports, volatile revenues can also introduce pressures on the trade balance. Rising oil prices and revenues tend to lead to a rise in imports of consumption goods and services. However, when export revenues fall, less revenue is available to import necessary intermediate and capital goods and services, creating the need for other financing sources. Generally, this situation leads to increases in public debt.

For the region as a whole, oil exports as a percentage of overall exports have declined over the past 20 years. Oil exports, on average, were 28 percent of total exports between 1980 and 1990 while oil exports from 1991 through 2000 averaged 16 percent. On the other hand, manufactured-exports’ share in total exports went from 27 percent on average for the 1980–90 period to 45 percent for 1991–2000.

In the region’s largest oil export–dependent economies, oil as a share of overall exports declined in the 1990s compared to the 1980s. Mexico and Bolivia show the sharpest declines. In Mexico, this share fell to an average of around 13 percent from 1991–2000, down from 53 percent, while oil as a share of exports in Bolivia dropped to 13 percent in the last decade compared to 40 percent in the 1980s. Ecuador’s oil-export share of total merchandise exports fell to 37 percent in the 1990s on average. In Venezuela, the decline is not as drastic as in the other net oil exporter countries. The share of oil exports as a percentage of total exports declined to 79 percent in the 1991–2000 period compared to 87 percent during the 1980s.

Mexico’s diversification of exports and consequent reduced dependency on oil revenue stands in marked contrast to Venezuela’s lack of diversification. As the process of economic reform was implemented in the region and Latin American markets became more open, Mexico pursued a strategy that led to a diversification in exports. Oil exports as a share of total exports began to fall in the mid-1980s as Mexico’s manufactured exports increased rapidly, in part through the expansion of the maquiladora sector. Maquiladoras are assembly plants, often located near the U.S.-Mexico border, where finished products made of imported parts are assembled and exported; they flourished during much of the 1990s under the North American Free Trade Agreement (NAFTA). A dramatic increase in Mexico’s total exports led to a decline in the share of oil exports. During the same time period Venezuela’s dependence on oil shrank only marginally because the country never diversified its export base.

Can Oil Stabilization Funds Reduce Macroeconomic Volatility?

Volatile oil prices can wreak havoc on oil-exporting countries. In order to ameliorate the negative impact of volatile oil prices, Colombia, Ecuador, Mexico and Venezuela have recently established oil stabilization funds. The funds are based on the argument that governments should save windfall earnings from periods when oil prices are high in order to spend such funds when prices fall.

Venezuela, for example, is more dependent on oil than any other country in Latin America with year-2000 petroleum-export revenue accounting for approximately 23 percent of gross domestic product, half of the government’s revenue, and 86 percent of exports. Consequently, the Venezuelan economy undergoes cycles of expansion and contraction associated with the price of oil. The economic swings are exacerbated by the fact that fiscal policy has traditionally been procyclical, with government spending rising during the boom years and shrinking when revenues fall. An oil stabilization fund is a tool that governments can use to enact countercyclical fiscal policies that could potentially reduce the disruptive impact of a sharp drop in the price of oil.

Venezuela’s brief experience with its Macroeconomic Investment and Stabilization Fund (known as the FIEM) suggests that stabilization funds are unlikely to be effective without a clear commitment to countercyclical fiscal policy. Since Venezuela’s “rainy day” fund began operation in 1999, it has accumulated $4 billion. The Chávez administration failed to make its obligatory deposits into the FIEM in 2001 and instead spent the funds on other government obligations. In 2002 the economy is expected to shrink by 4.4 percent, and government-financing needs are approximately $9 billion. While the government has announced that it will tap into the stabilization fund, the total resources in that fund are not enough to cope with the shortfall. Furthermore, the government is drawing on the FIEM at a time when oil prices are relatively high, rather than waiting for a “rainy day” when oil prices are low.

Net oil-importing countries
Many countries in Latin America, including Brazil, Peru and Chile, are net oil importers. Since petroleum is one of the main inputs for the production and distribution of goods and services, these imports are relatively inelastic to changes in oil prices, meaning that the consumption of fuel (including oil, lubricants, coal, natural gas and related products) varies little in response to changes in the price of oil. This inelasticity means that increases in oil prices will have a direct impact on the production costs of goods and services and can contribute to an increase in the inflation rate if these increased prices are passed on to the consumer.

During the 1980s, oil price hikes were one of the main factors that increased production costs in Latin America and contributed to higher inflation rates. As was the case with fuel exports as a share of total exports, however, fuel imports as a share of total imports declined in the 1990s. On average, fuel imports as a percentage of total merchandise imports in Latin America declined from 17 percent between 1980 and 1990 to 8 percent between 1991 and 2000.

Meanwhile, the share of manufactured imports as a percentage of total merchandise imports increased from 64 percent (1980 to 1990) to 76 percent (1991 to 2000).

The process of trade liberalization and economic opening helped bring about the increase in manufactured imports into the region in the 1990s. The economic reforms implemented in the early 1990s included the promotion of foreign investment and the adoption of new technologies and modes of production that spurred growth in imports of intermediate capital goods. Throughout Latin America inflation rates have been declining since the economic reforms of the 1990s, and the decline in the share of fuel imports as a percentage of total imports has served to further reduce the impact of fluctuating oil prices on the inflation rate.

Opening Up Mexico’s Protected Energy Sector

Mexico’s 1938 nationalization of its oil industry is an enduring symbol of national sovereignty and independence. The constitution grants Mexico’s national oil company, Pemex, the exclusive right to produce and explore oil and gas and prohibits it from selling such rights to a third party. As Mexico seeks to expand exploration, however, these restrictions on foreign investment become an increasing burden. Mexico has proven oil reserves of 24 billion barrels compared to 22 billion barrels in the United States. Yet Pemex by itself lacks the financial capacity to fund a rapid expansion in the exploration of these resources. Because the federal government receives 37 percent of its revenue from Pemex, the company is further limited by its crucial role in financing the public sector. For example, some analysts argue that with sufficient foreign investment, Mexico could begin exploiting its gas-rich Burgos Basin within two years, but Pemex would need seven years to carry out the project by itself.

In the face of political opposition, Mexican President Vicente Fox has pledged to increase international investment in the energy sector. Under current arrangements, foreign energy firms play a limited role and receive a flat fee to perform a specific task under a one- or two-year contract. Pemex has managed more than 1,100 of these contracts since 1997. A new government proposal would initiate multiservice contracts allowing a small number of firms to manage numerous service contracts that would last 10 or 20 years. Whether multiservice contracts will be upheld as constitutional is not clear, nor is it clear whether foreign firms will find their terms and conditions promising enough to merit the costs of large-scale investment. In the event that multiservice contracts do not take off and an increase in foreign investment does not materialize, Pemex — and Mexico — will have to continue to go it alone.

Good news and bad news
The impact of oil prices on Latin American economies varies depending on whether a given country is a net importer or a net exporter of oil. Whenever oil prices rise, countries like Venezuela or Ecuador that are net exporters of oil stand to benefit in the short run. On the other hand, net fuel importers like Chile and Peru are certain to cheer a drop in prices. Although some countries possess large oil reserves, the benefits of large oil revenues have not been fully exploited. In fact, the region’s policymakers have found it difficult to direct or channel these resources to other productive activities.

The fate of the region’s oil exporters suggests that it is the management of oil resources, not oil wealth itself, that can create economic distortions. In some cases, large oil revenues have depressed other economic sectors, curtailing their development and growth. In countries that are dependent on large oil exports, the volatility of oil prices has tended to add to economic uncertainty and instability.

For other oil-exporting countries in the region, structural reform and the expansion of trade have reduced most countries’ dependence on oil as the primary source of government revenue. Mexico is an example of one country that has greatly diversified its export base and is consequently far less dependent on oil exports than was the case 20 years ago. For Latin America, vast oil reserves can be a mixed blessing since oil itself is no guarantee of rapid economic development.

This article was written by Stephen J. Kay and Myriam Quispe-Agnoli of the Atlanta Fed’s Latin America Research Group.